The four principles of low-volatility equity investment

Recent market turbulence has heightened many investors’ interest in low-volatility equity strategies. While it’s well known that a portfolio of low-volatility stocks can potentially outperform the market over time (the “low-volatility paradox”), stock selection is important.

There are four investment principles which, our research suggests, can make a positive difference to the performance of a low-volatility portfolio when applied to the stock-selection process.

First―invest in stocks with attractive stability, quality and price. A key attribute of low-volatility stocks is their tendency to fall less than the broad market when sell-offs occur (because they fall less, they have less ground to make up when markets recover). So, it’s important to begin by looking for stocks with good price stability.

A focus on earnings and balance-sheet quality can help uncover stocks that may offer more lasting stability, while price or a reasonable valuation is always important, as stability should be bought at the best possible price. Quantitative research can help identify and analyse these factors.

Second―avoid "volatility traps", or stocks that have shown low volatility but could change. For example, a utility company in a sector undergoing a large-scale regulatory review might appear to be stable but could become volatile if the outcome of the review hurts the utility.

Quantitative research alone isn’t enough to protect against such risks, as stocks that score highly on quantitative factors can fall prey to unusual, real-life events. Good fundamental research, in addition to the quantitative analysis, can help guard against such risks.

Third―diversify away from the market index. This is particularly important in Australia, where the market is relatively small and dominated by financials, resources and a handful of large-cap stocks. Compared to markets overseas, some sectors and subsectors are virtually missing here, including those with lower-volatility industries, such as branded consumer goods and pharmaceuticals.

For these reasons, investors seeking to reduce volatility in their portfolios should consider small allocations to carefully chosen international stocks that can fill gaps in the Australian index.

Fourth―manage macro risks. In Australia, by just buying traditional “defensive” stocks with big index weights, it’s possible to end up with a portfolio dominated by REITs, utilities and infrastructure stocks―all sensitive to interest-rate risk.

Other macro risks include foreign exchange, US policy, European Union politics and China’s economy, to name a few. Careful portfolio construction should aim to identify and reduce them.